Tax considerations of bonds and bond funds

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By Dennis & Christopher Fagan
As we prepare to file our tax returns for calendar year 2015 and with interest rates hovering near multi-decade lows, suffice it to say that an investment in bonds carries a substantial degree of interest rate risk. (There is usually an inverse relationship between the direction of interest rates and the price of the underlying bond.) However, since bonds are much less volatile than stocks and do provide predictable streams of income, it is prudent for most to include them in their portfolios.
There are many different criteria to take into account when considering the purchase of an individual bond or bond fund. Some of these elements are applicable to both and some only for owners of individual bonds. These include who the issuer is; the time period between the date of purchase and the date of maturity; whether the bond is callable or non-callable; whether the bond is trading at a premium or a discount to par; what the interest rate will be and how often it will be paid. A final determining factor on the suitability of a bond purchase is, quite often, the most important—that is, the taxation of the income received from the bond and upon the sale of the security. This is the topic that we will address.
The vast majority of issuers of bonds can be classified into one of three categories: corporations; the United States government and its agencies; and state or local municipalities. When you buy an individual bond issued by a corporation or purchase shares in an open-ended Corporate Bond Fund, the interest you receive is taxable as ordinary income in the year in which it is paid. Additionally, should you sell a bond that you originally purchased at a discount to par value (the price at which the interest rate equals the current yield), at or above the purchase price you would pay capital gains taxes on the difference. Conversely, should you sell the bond for a loss, that loss would be a capital loss.
Should you purchase an individual bond issued by the United States government or one of its agencies or an Open-Ended Mutual Fund that invests in these bonds, there is a difference in the taxation as compared to a Corporate Bond or Corporate Bond Fund. A Government Obligation, issued as U.S. Treasury Bills, U.S. Treasury Notes and U.S. Treasury Bonds are taxable at the federal level, but exempt from State Income Tax. This also holds true for Open-Ended Mutual Funds. In addition, the treatment upon the sale of the bond or bond fund is exactly the same as a Corporate Bond or Corporate Bond Fund.
The final class of bond that we wish to discuss is one that is issued by a municipality. A bond issued by a municipality is tax-exempt at the federal level as well as in the state in which the bond is issued. This also holds true with a Municipal Bond Fund. The income is tax-exempt at the federal level and tax-exempt for the proportion of the income derived from bonds issued within your state of residency. For example, should you own a Municipal Bond Fund that invests in bonds of other states as well as NewYork State (your assumed state of residency for income tax purposes), only the income from the bonds issued by New York municipalities is tax-exempt at both the federal and state levels. All other income is tax-exempt at the federal level, but taxable at the state level.
Therefore, when deciding what type of bond best suits your needs, you must first determine your federal and state income tax brackets. Generally speaking, those in the 28% federal income tax bracket would be well served by a Municipal Bond or Municipal Bond Fund. Your state income tax bracket would determine whether to invest in a New York State Municipal Bond/fund or one that invests nationally. Conversely, should you be in a 15% federal income tax bracket, a Corporate or Treasury bond would be appropriate. Either way, check with your financial and tax advisor for the bond that best suits your objectives. Remember, when investing in bonds, what counts is not what you earn but rather what you keep after taxes!
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc. or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, please call 279.1044.

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